Yield, Value, Safety: Selected Property REITs Part 1

by: John D. Thomason

This is a continuation of the series of searching for stocks with the above listed attributes suitable for an income portfolio, this time focusing on Real Estate Investment Trusts (REITs). Note that in this article, REITs as discussed are property REITs, which own and/or manage income-producing real property, as opposed to mortgage REITs, which own portfolios of real estate mortgages, and employ leverage to generate returns. For my take on mortgage REITs, see my recent article on the topic here.

The approach of this article will be similar to my prior article on MLPs, in that I will initially focus on defining REITs, noting some of the differences between them and regular corporations. The overview will be supplemented with some links to some additional resources I have found helpful. I will then conclude Part 1 by defining Funds From Operations (FFO) for a REIT, and several of the various derivations of FFO frequently referenced in REIT reporting. In Part 2, I will present an approach to evaluating REITs, utilizing FFO and other values available from the income statement and balance sheet. I will then apply the evaluation methodology as defined to six REITs selected as representative examples. The goal of the article is to provide an individual investor with some insights and techniques such that any REIT of interest can be objectively evaluated.

REITs were initially authorized by the Real Estate Investment Trust Act of 1960, which specified that the special-purpose corporations authorized by the act would be exempt from corporate income tax if they met certain conditions. The purpose was to provide capital for real estate investment while allowing small investors to participate in significant real estate projects. Improvements from the original legislation were made in 1986 and again in 1999. From an individual investor's viewpoint, the most important REIT requirements are:

  • At least 90% of annual taxable income, excluding capital gains, must be distributed as dividends to shareholders. Any taxable income retained by the REIT is subject to corporate income tax. As a practical matter, most REITs distribute enough to shareholders to avoid corporate income taxation.
  • The REIT must have at least 75% of its assets invested in real estate, mortgage loans, ownership in other REITs, cash, or government securities.
  • The REIT must derive at least 75% of its gross income from rents, mortgage interest, or gains from property sales.

To qualify, a company must make a REIT election filing with the IRS, after the tax year. All REIT qualification requirements must have been met for the tax year just ended. There are additional restrictions besides those listed, related to concentration of ownership, relationships with subsidiaries, plus further quarterly and annual specifications on assets held and sources of income, which need not concern us here. For more detail, refer to the premier website on REITs, www.reit.com, sponsored by the National Association of Real Estate Investment Trusts (NAREIT). The section under REIT 101, entitled Forming a REIT, explains these requirements in detail. In addition to the unique REIT requirements, all SEC requirements for publicly-traded companies must also be met.

REIT dividends are reported to shareholders on form 1099-DIV, and may consist of ordinary income, capital gains, and return of capital. Each type of income is identified on the 1099:

  • Ordinary dividend income is taxed at the shareholder's normal rate. REIT dividends are not "qualified" for the special 15% dividend tax rate because they are from a tax advantaged entity. This distinction may become moot after 2012, as the tax break is set to expire after this year.
  • Capital gains distributions reported on form 1099 are reported as long-term capital gains, regardless of how long the REIT shares have been owned.
  • Return of capital distributions are not reportable as income. However, they reduce your basis in the REIT shares, and must be figured in accordingly when calculating the gain/loss on the REIT shares when sold.
  • Section 1250 unrecaptured gains from depreciable real property shown on the 1099 are included in capital gains, and are not reported directly on your return. This figure is used in completing the Schedule D worksheet in the IRS instructions, and may affect the tax on capital gains.
  • REITs do not generate Unrelated Business Taxable Income (UBTI), and can be held in retirement accounts without any UBTI concerns.
  • Even though REITs are "pass-through" entities, with income distributed to shareholders taxed only once, at the individual shareholder level, they cannot pass losses through to the individual shareholder.

The advantages of REITs as investments are many:

  • Diversification, from two perspectives; as an investment class alternative to regular corporate stocks or bonds, and as a real estate investment alternative to owning a single property or two. However, it should be noted that during the 2008-2009 financial crisis, REITs fell as hard, if not harder, as all other stock groups, and REITs cut dividends as much as any other stock grouping, with the possible exception of the banks. The theory of REITs not being correlated to the rest of the stock market, often touted by the industry, did not hold up when subjected to the severe stresses of that period.
  • Income, as REITs comply with the 90% distribution of taxable income requirement.
  • Inflation protection, since unlike most bonds, rents can be increased as conditions warrant at lease renewal time. Most if not all REIT long-term leases have inflation clauses.
  • Liquidity, whereby the investment in real estate can be entered and exited as easily as buying or selling stock, in contrast to traditional investments in real estate, which can take years to enter and exit.
  • Transparency, whereby the REIT's financial and property details are readily available to investors, by virtue of their being publicly-traded companies, subject to SEC reporting and governance requirements.

About the only disadvantage is when current income is not desired, and the only investment goal is significant stock price appreciation from growth. Since REITs pay out at such a high rate, they do not accumulate significant surplus funds for reinvestment, and are not likely to see much share price appreciation, at least not from internal growth through reinvestment of retained earnings. Expansion requires issuing stock or taking on debt. Of course, from the standpoint of imposing capital allocation discipline on management, this is actually a good thing. For investors wanting the advantages of a REIT, excluding the income, investment in a Real Estate Operating Company (NASDAQ:RLOC) might be a solution. A RLOC is similar to a REIT in operation, but has elected to pay corporate income tax as a regular corporation.

Several websites are listed below which expand upon these and other particulars of REITs:

The most comprehensive website for REIT information is the NAREIT website mentioned earlier, www.reit.com.

A May 1, 2012 article entitled "REITs: Looking Sweet on the Balance Sheet", presents an informative status update on REITs.

The always informative website, "How Stuff Works", has an interesting synopsis on REITs entitled, as you would expect, "How REITs Work".

Another article entitled "The Real Deal on REITs", presents an interesting rundown on REITs. The article is not dated, and the website may not be actively maintained, but the information on the referenced page is concise and informative, so I have included it.

The NAREIT website states that there are slightly more than 150 publicly-traded REITs, with an aggregate market capitalization of over $350 Billion. About 10% are Mortgage REITs, and the remaining 90% are Property REITs, also termed Equity REITs. Property REITs are frequently classified by the types of properties owned. While some REITs are diversified, with holdings of more than one type, most concentrate on only one major type. The major types are Retail, Office and Industrial, Health Care Facilities, Residential, Hotels and Lodging, and a smattering of various highly specialized categories. REITs are well represented in some of the major stock indexes, with 15 in the S&P 500, 25 in the S&P 400, and 30 in the S&P 600.

As a general rule, Residential and Healthcare REITs are the most recession-resistant categories, followed by Retail, then Office and Industrial, Hotels and Lodging. Healthcare Facility REITs especially have been standouts in recent years. Even so, I would not want to own more than one or at most two Healthcare Facility REITs, when I consider the slow-motion train wreck that characterizes healthcare delivery and funding in the U.S., and the uncertainty surrounding "Obama-Care".

Some of the qualitative evaluation factors to consider when evaluating a REIT are:

Management and Governance - Is managerial compensation in alignment with shareholder interests? Is the Board reasonably independent? What is the tenure and track record of the CEO and CFO?

Diversification - Is the income base diversified, or is 10% or more of revenue dependent on a single tenant? How many properties are in the portfolio? Is there geographic diversification? Diversification is partly a function of size, with the larger REITs able to own more properties in more geographic regions.

Lease Terms - What types of leases are employed? From the REIT standpoint, the ideal lease structure is the long-term 'triple net lease', where the lessee is responsible for taxes, insurance, and routine maintenance, in addition to rent. The ideal term is 15 to 20 years, with inflation escalation clauses built in.

Credit Rating, Established Lines of Credit, Debt Maturities - Any REIT with a credit rating lower than S&P BB, which is in the middle of the highest non-investment grade ranking, is suspect. Ideally, the rating should be S&P BBB-, the lowest investment grade ranking, or higher. If the REIT has an established credit line, how much has been drawn, and how much remains? Finally, when is debt due, requiring payment, or more commonly, roll-over? The financial crisis impacted some REITs severely when routine debt roll-overs became impossible to execute.

Occupancy and Trends - Obviously, only occupied properties generate income. A growing downtrend in occupancy is a matter of concern for any REIT.

Dividend History - What has occurred over the most recent five to ten years? Since this period encompassed the most severe economic crisis since the Great Depression, it should be an excellent indication of a REIT's ability to maintain payouts in times of stress.

Answers to these questions can often be determined from the periodic reporting by the REITs, available from their websites. They frequently provide supplemental menu selections or documents which list property details, recent and planned acquisitions and dispositions of properties, information on debt coming due and maturities, locations of properties, occupancy, and more. Additional information sources are analysts' reports generated by Wall Street firms, usually available for the larger REITs, which can be accessed through brokerages, or by subscription.

To evaluate REITs on a quantitative basis, the data source to use is again a REITs' own website. In addition to the required SEC filings, supplementary documents detailing Funds From Operations and derivatives are usually provided. Definitions of the unique REIT metric of FFO and derivatives are as follows:

Funds From Operations (FFO) - Defined by NAREIT as net income, with gains or losses from property sales backed out, and depreciation of real estate and amortization of capital expenditures for the period added back in.

Adjusted Funds From Operations (AFFO) - FFO is further adjusted by subtracting routine expenditures that are required to maintain properties, which are capitalized and amortized, and are thus included in the depreciation / amortization added back in when computing FFO. These expenses are actually recurring costs required to maintain the properties, and should be subtracted back out when determining funds available for other purposes. A second adjustment to FFO is to reflect actual cash rents received instead of the GAAP-required "straight-line" rent received which is reflected in net income. GAAP requires that rental income over a lease period be "straight-lined" to reflect what would be received for each reporting period segment, as if the total proceeds to be received over the lease period were paid in equal installments over the lease period. For example, if a lessee pays an upfront fee, the fee is pro-rated over the lease term when determining the reporting period rent contribution from that lease for GAAP net income, and thus FFO, even though it was received as a cash payment in full initially. AFFO, which is FFO as adjusted, reflects the actual rental cash received, not the "straight-line" value included in GAAP Net Income.

Cash / Funds Available for Distribution ((CAD / FAD)) - The NAREIT defines these as AFFO which is further adjusted to eliminate any non-recurring expenditures. Practically speaking, AFFO and CAD/FAD are equivalent.

Most if not all REITs report FFO, as defined by NAREIT, on a consistent basis, as part of their quarterly and annual reporting. They are not as consistent in how they define AFFO and CAD/FAD. Some report adjusted FFO as AFFO, while others report it as CAD or FAD. Others define "normalized" FFO as FFO adjusted to remove any non-recurring, infrequent items, which seems to be the same as the NAREIT definition for CAD/FAD. For purposes of evaluation, refer to the values supplied by the REIT as part of the routine quarterly and annual reporting, and pay close attention to any accompanying definitions. If provided, I will use CAD/FAD or AFFO to determine the Payout Ratio. If these are not provided, but normalized FFO is supplied, I will use normalized FFO to calculate the Payout Ratio. If only FFO is provided, I use that figure. For the REIT-unique calculation of Fixed Charge Coverage, I use AFFO or CAD/FAD if available, or normalized FFO if provided, or just FFO. For the FFO-based Return on Equity calculation, I just use the basic FFO. All of these REIT-unique metrics will be defined at length in Part 2.

Now, on to Part 2, evaluating specific REITs based on financial data and qualitative factors, with examples.

Disclosure: I am long SNH.